What is Return on Equity (ROE)
The Return on Equity (ROE) is one of the most important ratios to assess a company. It is considered as a conservative ratio to analyze a company, however, only ROE analysis is not enough; the analysis of other ratios is necessary to make an investment decision. To calculate ROE, company’s net profit is used as numerator and the total of average equity of shareholders is used as denominator.
Calculation of Return on Equity (ROE):
Return on Equity (ROE) Formula:
Return on Equity (ROE) % = [(Company’s Earnings X 100) ÷ The average equity of shareholders**] %
Here, company’s earnings = Company’s net profit after dividend payment of preference shareholders and before dividend payment of common shareholders. Dividend payment to common shareholders depends on company’s discretion, but dividend payment to preference shareholders is an obligation for company.
Here, Average Equity of Shareholders = [Shareholder’s equity at the beginning of the period + Shareholder’s equity at the end of the period] ÷ 2
** Average equity of shareholders excluding preference shares.
The ROE can also be derived by following formula:
Return on Equity (ROE) % = [(Company’s Dividend Growth Rate X 100) ÷ Earnings Retention Ratio] %
Here, Earnings Retention Ratio = 1 – Dividend Payout Ratio
Importance of Return on Equity (ROE):
Analysts use ROE to measure company’s growth ratio. To calculate company’s sustainable growth rate, multiply the company’s ROE to company’s earnings retention ratio. The sustainable growth rate tells the company’s efficiency that company can grow without debt.
In simple words, earnings retention is the remaining part of company’s total net income after dividend payment. This part may be reinvested or credited to company’s retained earnings. Company use its retained earnings for future goals and needs. The retained earning appears on company’s balance sheet in shareholders equity section.
Earnings Retention Ratio % = [(Total Net Income – Dividend Payment) X 100 ÷ Total Net Income] %
or Earnings Retention Ratio % = 1 – Dividend Payout Ratio %A stock may give a warning indication if its growth is far above or below than its sustainable growth rate. To calculate the ROE, company’s net income can be found from company’s income statement and shareholder’s equity can be found from company’s balance sheet. Some analysts also prefer to say ROE as Return on NAV.
The ROE ratio is one of the dearest ratios to investors, lenders, equity analysts, management and so on. The more ROE is considered that company’s management is more efficient to generate net income for its shareholders. The ROE vary industry to industry, that’s why, it is recommended to compare the companies of same industry. A higher ROE may be attractive for an industry, but it is not necessary that same ROE is also attractive for another industry, such as: below 10% ROE may be attractive to a capital-intensive industry, but it will not be considered as good as for technology industry.
There is no pre-set number to determine the ROE is bad or good, that’s why, it is good to compare the ROE with industry average. If the ROE of a company is above the average ROE of its industry, then the company will be considered good from the ROE point of view.
Return on Equity (ROE) Risk Indication and Limitations:
Sometimes ROE may become a reason of disagreements between analysts, as some analysts don’t include patents, goodwill, trademarks and other intangible assets into shareholder’s equity to compute ROE. However, ROE is one of the key ratios for fundamental analysis of a stock; investors, lenders and analysts all seek to higher ROE, but sometimes very high ROE may be a signal of problem or associated risks with a particular stock.
A higher number of ROE may appear attractive but it’s not enough. If a company has more debt and less size of equity, then ROE may be higher, but it is the risk indication. Inconsistent profit may also be a cause in big change of ROE. If big changes occur in ROE from one period to another period, then there is need to dig deeper, as it may be a risk indication.
Sometimes companies may also strategically increase its ROE without increasing of significant profit by taking excess debt which will ultimately reduce the equity portion and increase ROE. To increase ROE, companies may also buyback their shares which will reduce its total number of outstanding shares.
Only looking a higher number of ROE doesn’t tell a true picture of a company, as if a company has net loss and its shareholders equity is also negative then it will compute positive number of ROE and sometimes it may also give a big number of ROE, but in this scenario, companies is not compared with other companies.
Consistent negative ROE for several years may be an indication of severe problem. ROE should be calculated when equity and net income both are positive. Consistent losses reduce the retained earnings, ultimately shareholder’s equity reduces which may be a cause of higher ROE, that’s why, it is recommended to complete analysis behind the ratio before making an investment decision.
Frequently Asked Questions (FAQs)
Q. What is Return on Equity (ROE) meaning?
Ans. The ROE ratio is a conservative and one of the key ratios to measure a company’s profit generating ability to its shareholders equity. The net profit of company after paying the dividend to preference shareholders and before dividend payment of common shareholders is used as numerator and company’s shareholder’s equity excluding preference shares is used as denominator.The following formula is used to calculate ROE:
Return on Equity (ROE) % = [(Company’s Earnings X 100) ÷ The average equity of shareholders] %Q. What Return on Equity (ROE) is good?
Ans. There is no pre-set number for an ideal ROE, as ROE may vary industry to industry. A defensive industry or high capital-intensive industry may have a lower ROE than a cyclical industry. ROE should be compared with same industry peers and industry average.Q. What is the meaning of 1 Crore of 10 equity?
Ans. Someone wants 10% equity by investing 1 Crore in a company.Q. How to calculate company’s equity?
Ans. Equity = Total Assets – Total Liabilities
Company’s net income and shareholder’s equity can be found on company’s income statement and balance sheet, respectively.Q. How to Calculate Return on Equity (ROE)?
Ans. Return on Equity (ROE) % = [(Company’s Earnings X 100) ÷ The average equity of shareholders**] %
Here, company’s earnings = Company’s net profit after dividend payment of preference shareholders and before dividend payment of common shareholders. Dividend payment to common shareholders depends on company’s discretion, but dividend payment to preference shareholders is an obligation for company.Here, Average Equity of Shareholders = [Shareholder’s equity at the beginning of the period + Shareholder’s equity at the end of the period] ÷ 2
** Average equity of shareholders excluding preference shares.
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